Exotic Options
Binary options, barriers, and other non-standard option types
High Risk Instruments Warning
Exotic options are complex derivatives with unique risk profiles. Many are illiquid and designed for institutional use. Retail traders should approach with extreme caution.
Learning Objectives
Binary Options
All-or-nothing payoff structures
Cash-or-Nothing Calls
Pays fixed amount if underlying finishes above strike, zero otherwise.
Payoff:
If S > K at expiration: Receive $100
If S ≤ K at expiration: Receive $0
Asset-or-Nothing Options
Pays the underlying asset value if condition is met, zero otherwise.
Retail Binary Options Warning:
Many "binary options" marketed to retail traders are gambling products with unfavorable odds. Legitimate binary options are primarily institutional instruments.
Pricing Characteristics
Barrier Options
Options with path-dependent payoffs
Knock-Out Options
Option becomes worthless if underlying touches barrier level during life.
Up-and-Out
Dies if underlying rises above barrier
Down-and-Out
Dies if underlying falls below barrier
Knock-In Options
Option only becomes active if underlying touches barrier level.
Common Use:
Cheaper than vanilla options, used for hedging or speculation when barrier breach is expected
Practical Applications
Asian Options
Average price options for reduced volatility
Average Strike Options
Strike price is the average of underlying prices over the option's life.
Average Price Options
Payoff based on average underlying price vs fixed strike.
Payoff Example:
Max(Average Price - Strike, 0) for call option
Advantages
Other Exotic Structures
Lookback Options
Strike price or payoff based on maximum/minimum price during option life. Extremely expensive due to path dependency.
Chooser Options
Holder can choose whether option becomes call or put at predetermined date.
Compound Options
Options on options. Used in complex corporate finance structures and real options valuation.
Rainbow Options
Multi-asset options with payoffs dependent on performance of several underlyings.
Exotic Options Risks
• Liquidity Risk: Most exotic options cannot be easily sold before expiration
• Model Risk: Complex pricing models may not reflect true market value
• Counterparty Risk: Usually OTC products dependent on dealer's creditworthiness
• Path Dependency: Outcomes depend on price path, not just final price
• Regulatory Risk: Some jurisdictions restrict or ban certain exotic products
• Complexity Risk: Easy to misunderstand payoff structures and risks
When to Consider Exotic Options
Appropriate Use Cases
Key Takeaway:
Exotic options are specialized tools for specific situations. Most trading strategies can be accomplished with vanilla options at lower cost and complexity.